Markets & Startegy Page 3

In early economic theory, there is no "firm" in the modern sense. The business enterprise is simply an abstract producer of goods. Marshall termed this producer the "representative firm", which is a miniature economy or micro economy. The representative firm operates similarly to the larger economy - it maximizes self interest or profit and it efficiently allocates the use of resources it uses to achieve profit maximization. Within this model management is more akin to engineering in the sense that a firm must determine the most efficient combinations of resources needed to attain profit maximization. The amounts of resources that maximize profit can be determined through a mathematic expression, called a production function. If a production function can be stated, management is a decision-maker - deciding which combination of which types of resources best maximize profit. The assumption here is that the decision-maker is, in fact, motivated to maximize profits and knows the right kinds of resource combinations that will maximize profits in the future when production takes place.

At the center of the traditional economic view of the firm is the profit maximization assumption. Profit in the economic sense is the difference between price and costs. And, this is, generally, what we mean in business as "profits". But, there is one difference between economic profit and accounting profit that should be noted. To the economists, costs include accounting expenses, the costs of all resources consumed to make a product (labor, supplies, etc.), and opportunity costs, which are costs of time spent in making this specific product and all costs deferred in making this specific product as opposed to some other product. In practice, opportunity costs are typically not known, or not easily calculated, therefore, economic research tends to end up using the kinds of cost data available to the rest of us - that is, reported accounting costs. For simplicity, when I refer to profits or profit maximization, usually I will mean the difference between accounting costs and prices.

With this caveat, profit maximization can be illustrated by examining a firm's total revenues and costs:

MARKET PRICE	OUTPUT	TOTAL REVENUE	TOTAL FIXED COSTS	TOTAL VARIABLE COSTS	TOTAL COSTS
	Amount Produced and Sold	Price X Amount Sold	Costs for Producing Any Number	Total Costs for Producing More	Fixed Costs + Variable Costs
$ 5.00	1	$ 5.00	$15.00	$ 2.00	$ 17.00
$ 5.00	2	$10.00	$15.00	$ 3.50	$ 18.50
$ 5.00	3	$15.00	$15.00	$ 4.50	$ 19.50
$ 5.00	4	$20.00	$15.00	$ 5.75	$ 20.75
$ 5.00	5	$25.00	$15.00	$ 7.25	$ 22.25
$ 5.00	6	$30.00	$15.00	$ 9.25	$ 24.25
$ 5.00	7	$35.00	$15.00	$ 12.50	$ 27.50
$ 5.00	8	$40.00	$15.00	$ 17.50	$ 32.50
$ 5.00	9	$45.00	$15.00	$ 25.50	$ 40.50
$ 5.00	10	$50.00	$15.00	$ 37.50	$ 52.50

The same price and cost data can be examined to evaluate the level of output for profit maximization by calculating the rates at which revenues and costs change as output is increased. This is "marginal analysis". In marginal analysis the economist uses the data to calculate the added amount of revenue and costs with each increment of output to identify at which level of output is profit maximized:

Profit maximization in competitive markets exists when marginal revenue is equal to marginal costs:

OUTPUT	MARGINAL REVENUE	MARGINAL COSTS	AVERAGE TOTAL COSTS	UNIT PROFIT	TOTAL PROFIT
Amount Produced and Sold	Price for each unit sold.	Cost for producing more.	Total Costs ÷ Output	Revenue - Costs	Unit Profit X Output
1	$ 5.00	$ 2.00	$17.00	$ (12.00)	$(12.00)
2	$ 5.00	$ 1.50	$ 9.25	$ (4.25)	$ (8.50)
3	$ 5.00	$ 1.00	$ 6.50	$ (1.50)	$ (4.50)
4	$ 5.00	$ 1.25	$ 5.19	$ (0.19)	$ (0.75)
5	$ 5.00	$ 1.50	$ 4.45	$ 0.55	$ 2.75
6	$ 5.00	$ 2.00	$ 4.04	$ 0.96	$ 5.75
7	$ 5.00	$ 3.25	$ 3.93	$ 1.00	$ 7.01
8	$ 5.00	$ 5.00	$ 4.06	$ 0.94	$ 7.50
9	$ 5.00	$ 8.00	$ 4.50	$ 0.50	$ 4.50
10	$ 5.00	$12.00	$ 5.25	$ (0.25)	$ (2.50)

The economic assumptions that the firm is a profit maximizer has important implications:

The business firm is a reactor to its environment. The decisions that a firm must make are: What should it produce given alternative opportunities; how much labor should it use, given labor costs; and, how much of each raw material should it use in making the product, given prevailing supply costs. Labor and supply costs are dictated by their own markets. As a profit maximizer. the firm responds to changes in costs by varying its combinations of each to keep costs down and responds to prices by varying its level of production to keep prices up.

The business firm is identified with the investor/owner. In fact, the abstract economic firm assumes little about people involved in the enterprise. When we attempt to impose a "real world" and social understanding of business on the economic model, the party's whose interests are satisfied under profit maximization are the interests of the firm's owners who seek to obtain the highest possible yield on capital invested. [Although, arguably, the interests of the firm, as profit maximizer, are imposed on the owners, rather than the other way around.]

Because there is assumed in the profit maximization model that the decisions regarding level of production and combinations of resources are made without conflict and are non-political, implicitly, the owners either must be single individuals or, at least. owners with complete unanimity in decision making.

The firm also must exist in a single market and produce a single product. Since the firm is a reactor to market forces, the price mechanism is unique to each product and each market.

In short, the maximization assumption portrays the firm as a single market, single product asset of the owner who adapts a production plan in response to changing market conditions.